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CHAPTER

20

International

Business
Finance
LEARNING

OBJECTIVES

This chapter focuses on extending our financial decision-making horizons to


an international context. In particular it examines how the globalisation of
business requires financial managers to consider additional factors in making
financial decisions.
When you have completed this chapter you will:

understand the impact of the globalisation of product and financial markets


on the Australian economy;

Globalisation

The foreignexchange market

Interest rate
parity

11

Purchasing power
parity
13
Exposure to
exchange-rate
risk

17

Multinational
working-capital
management

23

be able to read and use foreign exchange rates;

appreciate the role of interest-rate parity and purchasing-power parity in


explaining exchange-rate determination;

be able to identify the impact of exchange-rate risk on the operations of


organisations;

International financing
and capital-structure
decisions
25

appreciate the factors influencing multinational working-capital management and international financing and capital-structure decisions;

Direct foreign
investment

26

understand the role of small and medium enterprises in developing exports.

Export and small


and medium
enterprises

29

How financial
managers use this
material
29
Summary

30

As more and more firms conduct business activities in more than one country,
financial managers need to consider additional factors in managing their
foreign operations. Moreover, because of the increasing international
integration of product and financial markets, most firms are subject to and are
influenced by international events and global economic forces. Thus, managers
of all companies must be sensitive to the international aspects of business
finance.
Firms can operate internationally in various ways. In the simplest
instance, a firm exports to (or imports from) a single foreign country. Other
firms operate in many countries simultaneously. For example, a number of the
national banks conduct business in many countries, resulting in them lending
in some currencies and borrowing in others. Many manufacturing companies
set up production facilities in foreign countries, selling the output back in the
home country, or selling it abroad.
Some companies have more elaborate international operations. For
example, a Japanese automobile company may have a plant in Australia for
manufacturing engines, another plant in Japan for automatic transmissions, a
third in Belgium for other components, and an assembly plant in Italy. The
final product, the automobile, may be destined for all markets in Europe and
Africa. This is an example of a multinational corporation (MNC).
The basic problems facing international companies differ from those
facing domestic companies. Examples of additional complexities of conducting
international business include the following:
1. Multiple currencies. Revenues may be denominated in one currency, costs in
another, assets in a third, liabilities in a fourth, and share price in a fifth.
Thus, the goal of maximisation of the wealth of the owners must consider
changing currency values.
2. Differing legal and political environments. International variations exist in
tax laws, depreciation allowances and other accounting practices, as well as
in government regulation and control of business activity. Repatriation of
profits may be a problem in certain countries.1
3. Differing economic and capital markets. The extent of government
regulation and control of the economy and capital markets may differ
greatly across nations. For example, the ability of a company to raise
different types and amounts of capital in its home financial market may be
restricted.
4. Internal management and central control. It may be difficult to organise,
evaluate and control different divisions of a company when they are
separated geographically and when they operate in different environments.

GLOBALISATION
Globalisation refers to the economic interrelationship of national economies
and their firms.
An illustration of globalisation is given by the growth in world trade as a
percentage of world aggregate output (global gross national product (GNP)).
In the early 1960s global exports and imports were about one-fifth of global
aggregate output whereas today they are more than one-third and are likely to
grow even further.
In addition to the significant increase in world trade in recent years, there
has also been a rise in the global level of international direct and portfolio
investment. Direct investment refers to investment by a company in an overseas
business over which it has control, such as when it builds an off-shore
manufacturing facility or purchases the majority of the shares in an overseas
company. Portfolio investment involves investment overseas in financial assets
with maturities greater than one year, such as foreign shares and bonds, where
the investor does not have control over the management of the investments.
The motivation for portfolio investment is twofold: to obtain returns higher
than those obtainable in the domestic capital markets and to reduce portfolio
risk through international diversification.
The increase in world trade and investment activity is also reflected in the
globalisation of financial markets. For example, the globally integrated foreignexchange markets have grown rapidly in the last twenty years.
An important point for financial management is that even a purely
domestic firm that buys all its inputs and sells all its output in its home country
is not immune to globalisation, nor can it totally ignore the workings of the
international financial markets.

direct investment Investment


directly in plant and equipment.

portfolio investment
Investment in financial assets such
as shares and bonds.

THE FOREIGN-EXCHANGE MARKET


The foreign-exchange market facilitates the exchange of currencies of different
countries. The exchange rate between two currencies that is quoted on the
foreign-exchange market provides a mechanism for the transfer of purchasing
power from one currency to the other. An interesting feature of the foreignexchange market is that it is not located in one physical place but comprises an
international network of electronic connections (telephone, fax, telex,
computer, Reuters and Telerate data display screens) between foreign-exchange
dealers, brokers and customers. In Australia about 70 foreign-exchange dealers
comprising banks and other finance organisations are licensed by the Reserve
Bank to buy and sell foreign currencies. Foreign-exchange brokers are other
organisations which act as intermediaries between the other market
participants.

foreign-exchange market
The market in which currencies are
exchanged.

efficient market A market in


which the values of all assets and
securities at any instant in time
fully reflect all available
information.

spot transaction A transaction


where delivery will occur
immediately. For foreign exchange,
this delivery is, by convention, two
business days after the spot
transaction is agreed to.
spot exchange rate The
exchange rate quoted today for the
exchange of currencies in two
business days time.

The foreign-exchange market operates simultaneously at two levels. At


the first level, customers buy and sell foreign exchange (i.e. foreign currency)
through the banks. This is called the retail segment of the foreign-exchange
market. At the second level, dealers buy and sell foreign exchange from other
dealers in the same country, from dealers in foreign-exchange markets located
in other countries or from their large corporate clients. This is called the
interbank or wholesale segment of the foreign-exchange market.
An example will illustrate the international dimension of foreignexchange trading. An importer in Perth may buy foreign exchange (e.g. UK
pounds) from its banks foreign-exchange section to make payment to a British
supplier. The Australian bank, in turn, may purchase the foreign currency
(pounds) it provides to the importer from a Singapore bank which may buy the
pounds from another bank in Singapore or from a bank in London.
Because this market provides transactions in a continuous manner for a
very large volume of sales and purchases, the currency markets are efficient in
the sense that it is difficult to make a profit by shopping around from one
dealer to another. Minute differences in the exchange-rate quotes from
different dealers are quickly eliminated. Because of this arbitrage mechanism
(discussed later), simultaneous quotes by different dealers in Sydney, Singapore
and London are likely to be the same.
Two major types of transactions are carried out in the foreign-exchange
markets: spot transactions where the currencies are exchanged at the spot rate
and forward transactions where the currencies are exchanged at the forward
rate.
Spot transactions
A typical spot transaction involves an Australian firm buying foreign currency
from its bank and paying for it in Australian dollars. Another type of spot
transaction occurs when an Australian firm receives foreign currency from
abroad and sells the foreign currency to its bank for Australian dollars. These
are both called spot transactions, because one currency is exchanged for
another currency today. To allow time for the transfer of funds between the
customer and the bank, the value date when the currencies are actually
exchanged is two business days after the date the spot transaction is agreed to.
Spot exchange rates are quoted by foreign-exchange dealers to apply to
spot transactions with their customers and comprise two figures. The first is
the rate at which the dealer is prepared to buy one currency in exchange for
another and the second is the rate at which the dealer is prepared to sell one
currency in exchange for another.
Because every foreign-exchange transaction will involve two currencies,
we need to know which currency is being bought and sold and for how much

of the other currency. On the foreign-exchange market in Australia, the


exchange rate involving the Australian dollar which is quoted to retail
customers indicates the number of units of the foreign currency the dealer is
prepared to buy and sell in exchange for one unit of the AUD.
Looking at the exchange rates in the retail market of Table 20.1 we can
see that the bank is prepared to buy US$0.5360 from a customer in exchange
for A$1 and is prepared to sell US$0.5310 to a customer is exchange for A$1.
Similarly, the exchange rate quoted between the UK pound and the AUD is the
rate at which the bank is prepared to buy stg 0.3780 from a customer in
exchange for AUD 1 and is prepared to sell stg 0.3716 to a customer
in exchange for AUD 1.
You will also notice that for the US$, stg and Euro there is a second set
of exchange rate quotations. These are expressing the standard quotes as an
A$ equivalent and are simply the reciprocal of the first quotes. To preserve the
buy and sell relationships of the standard quotes, the A$ equivalent rates need

TABLE 20.1

RETAIL FOREIGN EXCHANGE RATES


AUSTRALIA DOLLAR
RETAIL MARKET
BUY/SELL

BUY/SELL

United States, dollar

0.5360/0.5310

N Zealand, dollar

1.2275/1.219

$Aust equivalent

1.8657/1.8832

Norway, krone

5.0528/4.965

UK, pound

0.3780/0.3716

Pakistan, rupee

On App.

$Aust equivalent

2.6455/2.6910

Papua NG, kina

On App.

Europe, euro

0.5670/0.5499

Philippines, peso

On App.

$Aust equivalent

1.7636/1.8185

Saudi Arabia, riyl

2.7737/2.705

Brunei, dollar

1.1123/1.0930

Singapore, dollar

1.1142/1.094

Canada, dollar

1.0174/0.9997

Solomon Is, dollar

2.4516/2.371

Denmark, kroner

4.5622/4.4828

S Africa, rand

2.6539/2.595

Fiji, dollar

1.0763/1.0459

Sri Lanka, rupee

36.26/35.51

Sweden, krona

5.8104/5.710
0.9625/0.945

Fr Pacific, franc

72.25/70.31

Hong Kong, dollar

5.7108/5.6145

Switzerland, franc

India, rupee

23.003/21.893

Thailand, baht

18.53/18.14

On App.

Tonga, paanga

0.9668/0.921

Indonesia, rupiah
Japan, yen
Malaysia, ringgit
Malta, pound

73.84/72.54
On App.
0.2779/0.269

Vanuatu, vatu

84.92/82.78

W Samoa, tala

1.8547/1.768

Gold - 1 oz

506.74/518.8

On App. = On Application

to be read as the number of A$ that the bank is prepared to exchange to buy or


sell one unit of the foreign currency. For example, with the USD the bank is
advising that it will pay A$1.8657 to a customer in exchange for (the bank
buying) US$1 and the bank will take from a customer A$1.8832 in exchange
for (the bank selling) US$1.
Let us now put these exchange rates to use with some examples.

EXAMPLE

20.1

You are about to travel to both the United States and the United Kingdom for
two months holiday and you want to obtain US$2,000 and stg 1,000 before
you go. Using the retail rates quoted in Table 20.1, how many A$ will this cost
you?
The purchase by you of the foreign currencies will require the bank to
sell these foreign currencies to you and consequently the quoted sell rates will
be used to determine the amounts to be exchanged. We can use either the
standard exchange rate quote or the A$ equivalent quote:
1. Standard quote. The right-hand rate, detailing the rate at which the bank
will sell foreign currencies, will apply to your spot transaction:
US$: The bank is quoting it will sell to you US$0.5310 for A$1.
Therefore, to obtain US$2,000 you will have to pay to the bank
2,000/0.5310 = A$3,766.
stg: The bank is quoting it will sell to you stg 0.3716 for A$1.
Therefore, to obtain stg 1,000 you will have to pay to the bank
1,000/0.3716 = A$2,691.
2. A$ equivalent quote. The right-hand rate, detailing the rate at which the
bank will sell one unit of the foreign currency to you, will apply to your
transaction:
US$: The bank is quoting it will sell to you US$1 for A$1.8832.
Therefore, to obtain US$2,000 you will have to pay to the bank 2,000
1.8832 = A$3,766.
stg: The bank is quoting it will sell to you stg 1 for A$2.6910.
Therefore, to obtain stg 1,000 you will have to pay to the bank 1,000
2.6910 = A$2,691.

EXAMPLE

20.2

An Australian business must pay 1,000 Euros to a German firm. How many
dollars will be required for this transaction using the rates from Table 20.1?
As the business wants to buy Euro, the bank will have to sell Euro and it
is quoting to sell Euro at a rate of s0.5499 for A$1. Therefore, to buy s1,000
the business would have to pay 1,000/0.5499 = A$1,818 to the bank.
EXAMPLE

20.3

An Australian business has received 1 million Yen which it wants to exchange for
A$. How many A$ will the business receive at the rates quoted in Table 20.1?
As the business wants to sell Yen, the bank will have to buy Yen and it is
quoting a buy Yen rate of Yen 73.84/A$1. Therefore, to sell its Yen 1 million,
the business would receive 1,000,000/73.84 = A$13,542.79 from the bank.

Exchange rates and arbitrage


The foreign-exchange market is international, with dealers around the world
linked electronically with each other. Therefore, at any point in time the
exchange rate quoted in different countries for the same currencies should be
the same. If the exchange-rate quotations were out of line, then an enterprising
trader could make a profit by buying in the market where the currency was
cheaper and selling it in the other. Such a buy-and-sell strategy would involve
a zero net investment of funds with no risk, yet would provide a sure profit.
A person who undertakes such activity is called an arbitrageur, and the process of buying and selling in more than one market to make a riskless profit is
called arbitrage. Spot exchange markets are said to be efficient in the sense that
arbitrage opportunities do not persist for any length of time. That is, the
exchange rates between currencies quoted in two different markets are quickly
brought in line, aided by the arbitrage process. Simple arbitrage eliminates
exchange-rate differentials across the markets for a single currency. Triangular
arbitrage does the same across the markets for all currencies. Covered interest
arbitrage eliminates differentials across currency and interest-rate markets.
Bid and ask (offer) rates
As we have seen above, each exchange-rate quotation has two components, the
buy rate and the sell rate. In foreign-exchange market terminology these are
called the bid and ask rates respectively. Therefore, with our examples, the bid
rate is the rate at which the dealer buys the foreign currency from the customer.
The ask rate is the rate at which the dealer asks the customer to pay in home

arbitrageur A person involved


in the process of buying and selling
to make a riskless profit.
arbitrage Buying and selling in
more than one market to make
a riskless profit.

bid rate Rate at which a


foreign-exchange dealer will buy
one currency in exchange for
another.
ask (offer) rate Rate at which
a foreign-exchange dealer will sell
one currency for another.

bid-ask spread The difference


between the buying and selling
foreign-exchange rates.

cross rates The computation of


the exchange rate of one currency
with another from the exchange
rates of each of the currencies with
a common third currency.

forward exchange contract


A contract that requires the
delivery of one currency at a
specified future date for a specified
amount of another currency.
forward exchange rate The
exchange rate quoted today for the
exchange of currency more than
two business days in the future.

currency for foreign currency sold by the dealer. The ask rate is also known as
the offer rate.
From the buy/sell (bid/ask) rates in Table 20.1 we can see that the bank
buys more foreign currency from a customer per A$ than it sells to a customer.
The difference is known as the bid-ask spread. When there is a large volume of
transactions exchanging two currencies and the trading is continuous, the bidask spread is small and can be less than 0.5% of the spot rate for the major
currencies. The spread is much higher for infrequently traded currencies. For
example, looking at the rates quoted in Table 20.1, we can see that for the
US$/A$1 rate the spread is equal to 0.5360 0.5310 = US$0.005/A$1, which is
approximately 0.9% of the spot rate, whereas for the Indian rupee the spread is
23.003 21.893 = Rp 1.11/A$1, which is approximately 5.0% of the spot rate.
The spread exists as a margin to compensate the banks for holding the risky
foreign currency and for providing the service of exchanging currencies.
Cross rates
The listing of the retail market exchange rates in Table 20.1 in each case
involves the Australian dollar as one of the currencies. What happens if you
want a rate to exchange two other currencies? For example, you might have
come back from your overseas trip with US$1,000 and you want to exchange
it to New Zealand dollars. At what rate would the banks effect this exchange?
This rate is called a cross rate and is derived from the exchange rates between
the two currencies concerned and a common third currency. In this case we
could use the US$/A$1 and NZ$/A$1 rates to calculate a US$/NZ$ cross rate.
In practice, this examples calculation would not be done because in the
foreign-exchange market every currency has a primary exchange rate quotation
which is its rate against the US$ (e.g. US$/NZ$, US$/A$). Then the exchange
rates between every other pair of currencies that doesnt include the US$ are
calculated as cross rates. Therefore in Table 20.1 the US$/A$ exchange rate is
the primary exchange rate for A$ and all the other rates that are quoted (which
dont include the US$) are in fact cross rates.
Forward exchange contract
A forward exchange contract is an agreement between a customer and a
foreign-exchange dealer which requires delivery, at a specified future date after
the spot date, of one currency for a specified amount of another currency. The
exchange rate for the forward transaction is called the forward exchange rate
and is agreed today; with the actual payment of one currency and the receipt of
the other currency taking place at the future date specified in the contract. For
example, a 30-day forward contract entered into on March 1 will require
delivery of the currencies on March 31. Note that the forward rate quoted
today is not likely to be the same as the spot rate that will apply in the future,

as that spot rate will depend on the market conditions at that time and it may
be more or less than todays forward rate. Therefore, we can identify exchangerate risk as the risk that tomorrows spot exchange rate will differ from todays
spot rate and that there is uncertainty as to what tomorrows spot rate will be.
Why would you use a forward exchange contract? Suppose you are an
Australian exporter who is going to receive a payment denominated in pounds
from a British customer in 30 days. If you wait for 30 days and exchange the
pounds at the spot rate, you will receive an Australian dollar amount reflecting
the exchange rate 30 days hence (i.e. the future spot rate). As of today, you
have no way of knowing the exact dollar value of your future pound receipts.
Consequently, you cannot make precise plans about the use of these dollars.
On the other hand, if you agree today to a forward contract in which the rate
of exchange to apply in 30 days time is known, then you know the exact dollar
value of your future receipts, and you can make precise plans concerning their
use. The forward contract, therefore, can reduce your uncertainty about the
future, so a major advantage and use of the forward market is that of risk
reduction.
Forward contracts are usually quoted for monthly periods (e.g. 1 month,
2 months etc.). A contract for any intermediate value date can be obtained,
usually with the payment of a small premium.
Forward rates, are quoted as a margin to be added to or subtracted from
the current spot rate.

exchange-rate risk The


variability of future cash flows
caused by variations in exchange
rates.

Examples of exchange-rate risk


The concept of exchange-rate risk introduced above applies to all types of
international businesses. The measurement of these risks, and the type of risk, may
differ among businesses. Let us see how exchange risk affects international trade
contracts, international portfolio investments, and direct foreign investments.
Exchange-rate risk in international trade contracts
The idea of exchange-rate risk in trade contracts is illustrated in the following
situations.
Case I:
A Brisbane new-car dealer contracts to buy cars from the manufacturer in
Melbourne. The dealer agrees to pay A$10,500 on delivery of each car, which
is expected to be 30 days from today. The cars are delivered on the 30th day
and the distributor pays $10,500 each. Notice that, from the day this contract
was written until the day the cars are delivered, the buyer knew the exact
Australian dollar amount of the liability. There was, in other words, no
uncertainty about the value of the contract.
Case II:
A Perth new-car dealer enters into a contract with a British supplier to buy cars

FIGURE 20.1

Probability

A SUBJECTIVE
PROBABILITY
DISTRIBUTION OF THE
POUND EXCHANGE
RATE (A$ EQUIVALENT),
30 DAYS IN THE FUTURE

2.5000
2.7000
Australian dollars per pound

from the United Kingdom for 5,500 pounds each. The amount is payable on
the delivery of the cars, 30 days from today. From Figure 20.1, we see the
range of spot rates that we believe can occur on the date the contract has to be
paid. On the 30th day, the Australian importer will pay some amount in the
range of A$13,750 (5,500  2.500) to A$14,850 (5,500  2.700) for each car.
Today, the Australian firm is not certain what its future dollar outflow will be
30 days hence. That is, the Australian dollar value of the contract is uncertain.
These two examples help illustrate the idea of foreign-exchange risk in
international trade contracts. In the domestic trade contract (Case I), the exact
dollar amount of the future dollar payment is known today with certainty. In
the case of the international trade contract (Case II), where the contract is
written in the foreign currency, the exact dollar amount of the contract is not
known. The variability of the future spot exchange rate induces variability in
the future dollar cash flow.
Exchange-rate risk exists when the contract is written in terms of the
foreign currency, that is, denominated in a foreign currency. There is no direct
exchange risk if the international trade contract is written in terms of the
domestic currency. In Case II, if the contract were written in Australian dollars,
the Australian importer would face no direct exchange risk, whereas the British
exporter would bear all the exchange risk because the British exporters future
pound receipts would be uncertain. That is, the British exporter would receive
payment in Australian dollars, which would have to be converted into pounds
at an unknown (as of today) pound-Australian dollar exchange rate. In
international trade contracts of the type discussed here, at least one of the two
parties to the contract always bears the exchange risk.
Certain types of international trade contracts are denominated in a third
currency, different from either the importers or the exporters domestic
currency. In Case II the contract might have been denominated in, say, the
Euro. With a Euro contract, both importer and exporter would be subject to
exchange-rate risk.
Exchange risk is not limited to two-party trade contracts; it exists also in
foreign portfolio investments and direct foreign investments.
Exchange risk in foreign portfolio investments
Let us look at an example of exchange risk in the context of portfolio
investments. An Australian investor buys shares in a German company which
are listed on the German stock exchange. The exact return on the share
investment is unknown. Thus, the share is a risky investment. The investment
return in the holding period of, say, three months stated in Euros could be
anything from 2 to +8%. In addition, the Australian dollar may be worth
more or less Euros in the three-month period during which the investment is

10

held. The return to the Australian investor, in Australian dollars, will therefore
be dependent on the return from the investment as well as the future Euro/A$1
spot exchange rate. Clearly, for the Australian investor, the foreign-exchange
factor induces a greater variability in the Australian dollar rate of return.
Hence, exchange-rate fluctuations may increase the riskiness of foreign
investments.
Exchange risk in direct foreign investment
The exchange risk of a direct foreign investment (DFI) is more complicated
than a portfolio investment. In a DFI the parent company invests in assets
denominated in a foreign currency with the result that the balance sheet and
the income statement of the foreign investment will be in terms of the foreign
currency. Thus, the exchange risk concept applies to fluctuations in the homecurrency value of the net assets located abroad as well as to the fluctuations in
the home-currency-denominated profit stream. Exchange risk not only affects
immediate profits, but it may affect the future profit stream as well.
Although exchange-rate risk can be a serious complication in
international business activity, remember the principle of the risk-return tradeoff. Traders and companies find numerous reasons why the returns from
international transactions outweigh the risks. We will return to examining
exchange-rate risk later.
INTEREST RATE PARITY
The convention in the foreign-exchange market is that forward rates are
quoted as a margin to be added to or subtracted from current spot rates. When
comparing the current spot rate with a current forward rate we can say that
the currencies to be exchanged are trading at a forward discount or forward
premium. For example, the Australian dollar is trading at a forward discount if
the current forward rate (e.g. 30 days) has less foreign currency per A$1 than
the current spot rate, and is trading at a forward premium if the current
forward rate (e.g. 30 days) has more foreign currency per A$1 than the current
spot rate.
We can calculate the annual percentage amount of the forward discount
or premium of the home currency (e.g. A$) in relation to another currency
from the respective spot and forward rates as follows:
P (or D) =
where

F S 12

100
S
n

(20-1)

n = number of months in the forward contract


P = the annualised percentage premium, if F > S
D = the annualised percentage discount if F < S

11

EXAMPLE

20.4

The 30-day forward Euro is selling at s0.5490 per A$1, whereas the current
spot rate is s0.5499 per A$1. This difference represents a forward discount
percent p.a. for A$ of:
0.5490 0.5499  12 
100 = 1.96%
0.5499
1
That is, A$1 is worth 1.96% fewer Euros forward than currently at spot.

interest rate parity theory


Proposes that (except for the effect
of small transaction costs) the
difference between the current spot
and forward exchange rates should
reflect the differences in the
national interest rates for securities
of the same maturity.

Forward premiums and discounts differ between currencies and between


maturities for the some currencies because they are determined solely by the
difference in the level of interest rates between the two countries, called the
interest rate differential. In fact the value of the forward premium or discount
can be theoretically computed from the interest rate parity (IRP) theory. This
theory states that (except for the effects of small transactions costs) the
forward premium or discount should be equal to the difference in the national
interest rates for securities of the same risk and maturity.
Specifically, the premium or discount on a percent-per-annum basis
should be equal to
P (or D) =

(I

Id

1 + I

(20-2)

where P (or D) = the % p.a. (expressed as a decimal) premium (or


discount) on the forward rate
f
I = the annualised interest rate on a foreign instrument
having the same maturity as the forward contract
d
I = the annualised interest rate on a domestic instrument having the same maturity as the forward
contract
To compute the forward discount/premium on, say, a 30-day forward
Euro contract, we would need the 30-day treasury-bill rate in Australia and its
counterpart in Europe, both expressed as annual rates.
When the interest rates are relatively low, equation (20-2) can be
approximated by:
P (or D) If Id

(20-3)

Using the answer from the previous example and equation 20-2, IRP says
that the 30-day interest rate in Euro must be approximately 1.96%
(annualised) less than the 30-day treasury-bill rate in Australia.

12

Covered interest arbitrage


The rationale for IRP is provided by the covered interest arbitrage argument.
This argument states that if the premiums (or discounts) reflected in current
forward rates are not exactly equal to the current interest-rate differential
(approximately equal to the right-hand side of equation 20-3), then arbitrage or
riskless profits can be made.
This arbitrage would be accomplished by simultaneously borrowing in
one money market, investing in another money market, and covering the
exchange position in the forward-exchange market. The entire process is
known as covered interest arbitrage.
So, an arbitrage profit would be possible when the forward discount
from the actual exchange rates is not equal to the forward discount required
from the interest-rate differential. Under such circumstances, arbitrageurs enter
the market, increase the demand for the forward foreign currency, and drive up
the price of the forward contract. The equilibrium price of the forward
contract would then obey the IRP theory.
Therefore, if the forward contract rate quoted in the foreign-exchange
market is different from the computed price, there is the potential to make
arbitrage profits using the covered-interest-arbitrage routine.
The forward markets are efficient in the sense that the quotes in the
market represent the correct price of the contract. The markets efficiency
also implies that no profit can be made by computing the prices at every
instant and buying/selling forward when they appear incorrect. Some minor
deviations from the computed correct price may exist for short periods. These
deviations, however, are such that after the transactions costs have been
recognised, no net profit can be made. Numerous empirical studies attest to the
efficiency of the forward markets.
PURCHASING POWER PARITY
Long-run changes in spot exchange rates are influenced by international
differences in inflation rates and the purchasing power of each nations currency.
For example, the foreign exchange value of the currency of countries with high
rates of inflation will tend to decline. This is because according to the
purchasing power parity theory (PPP), spot exchange rates will tend to adjust in
such a way that each currency will have the same purchasing power (especially
in terms of internationally traded goods). Thus, if the United Kingdom
experiences a 4% rate of inflation in a year that Europe experiences only a 2%
rate, the UK currency (the pound) will be expected to decline in value by
approximately 2% (4% 2%) against the Euro. More accurately, according to
the PPP:

purchasing power parity


theory Proposes that in the long
run, exchange rates adjust so that
the purchasing power of each
currency tends to remain the same
and, thus, exchange-rate changes
tend to reflect international
differences in inflation rates.
Countries with high rates of
inflation tend to experience
declines in the value of their
currency.

13

St+1 = St ( 1 + Pf ) / (1 + Pd )n
St ( 1 + Pf Pd )n
where St+1 = the spot exchange rate (units of foreign currency per
unit of the domestic currency) at time t + 1
St = the exchange rate at time t
Pf = the foreign inflation rate
Pd = the domestic inflation rate
n = number of time periods
Thus, if the beginning value of the Euro was 0.40/s1, then a 2%
inflation rate in Europe and a 4% inflation rate in the United Kingdom would
mean that to purchase the same goods in 12 months would require either
0.416 (i.e. 0.40 1 + 0.04) or s102 (i.e. 100 1 + 0.02). According to the
PPP, this would result in the expected spot exchange rate of the Euro at the end
of that year (St+1) to be 0.40 (1.04/1.02), or 0.408. This is the rate that
will convert 0.416 to s102 and thereby preserve the purchasing power of the
two currencies.
The law of one price
Underlying the PPP relationship is the law of one price. This law is actually a
proposition that, in competitive markets where there are no transportation
costs or barriers to trade, the same good sold in different countries sells for the
same price if all the different prices are expressed in terms of the same
currency. The idea is that the worth (in terms of marginal utility) of a good
does not depend on where it is bought or sold. Because inflation will erode the
purchasing power of any currency, its exchange rate must adhere to the PPP
relationship if the law of one price is to hold over time. The following example
illustrates the workings of this proposition.
Given the information above, assume that today a widget costs s100.00
in Germany and 40.00 in the United Kingdom. At the current exchange rate
of 0.40/s the law of one price appears to be holding since Germans can buy
British widgets for s100.00 (40 0.40/s), and the British can buy German
widgets for 40.00 (s100 0.40/s). It is possible to determine how the
exchange rate must change for the law of one price to hold in relative form
for example, over the next year. We might expect that the exchange rate will
change to reflect the decline in each currencys domestic purchasing power
caused by next years inflation. Today we know:
s100.00 = 1 widget = 40.00
At this point, it would make no difference whether Germans bought
German widgets or British widgets. Given that inflation in the United
Kingdom is expected to be 4%, one British widget can be expected to cost

14

41.60 = (40.00)(1 + 0.02). At the current exchange rate (0.40/s), in one


year British widgets would cost Germans s104.
s104 = 1 widget = 41.60
= 41.60 40/s
If we ignore the effects of German inflation for the moment, Germans
would not buy British widgets for s104 in one year; they would buy German
widgets for s100. Thus, at the current exchange rate, PPP would not hold.
Germans might, however, be willing to continue spending s100 one year from
now for British widgets. This could happen only if the Euro were to strengthen
against the pound. If this were to occur the new exchange rate suggested by the
United Kingdom inflation is:
s100 = 1 widget = 41.60
(/s) = 41.60 s100 = 0.416/s
or:
(/s) = 0.40 (1 + PUK) = 0.40 1.04
Note that the terms of trade are important. Germans want the same
amount of goods for the same number of Euro before and after the British
inflation. After the British inflation, the Euro buys more pounds at the new
exchange rate (0.416/s1). Note also that the British will be paying 40.00
per widget in todays poundsall British goods will cost 4% more next year
because of inflation. That is, although widgets will cost more in nominal
terms next year in the United Kingdom, the real cost of widgets will be
unchanged.
Now we will consider German inflation. Because the Euros purchasing
power is expected to decline by 2% over the next year, Germans would be
willing to pay s102.00 [s100 (1 + PGer)] for a British widget in one year
because this is what they would have to pay for a German widget at that time.
The new exchange rate becomes the same as the PPP estimate calculated earlier.
s102 =1 widget = 41.60
(/s) = 41.60 D102 = 0.408/s
or:
(/s) = 0.40 (1 + PUK)/(1 + PGer) = 0.408/s
International Fisher Effect (IFE)
According to the domestic Fisher effect (FE), nominal interest rates (i) which
are observed in the financial markets reflect the expected inflation rate (r) and
a real rate of return (R):

15

1+i=(1+R)(1+r)
and
i = R + r + rR
While there is mixed empirical support for the Fisher effect
internationally (IFE), it is widely thought that, for the major industrial
countries, the real rate, R, is about 3% p.a. when a long-term period is
considered. In such a case, with the previous assumption regarding inflation
rates, the annual nominal interest rates in the United Kingdom and Germany
would be 7.12% [ (1 + 0.03) (1 + 0.04) 1] and 5.06% [ (1 + 0.03) (1 + 0.02)
1] respectively.
In addition, according to Interest Rate Parity (IRP), the expected premium
for the Euro forward rate should be 1.96% [(0.0712 0.0506)/1.0506]. Starting
with a current spot rate value of 0.40/s gives us a one-year forward rate of
0.40 (1.0196) = 0.408/s. As you may notice, this one-year forward rate is
exactly the same as the PPP expected spot rate one year from today. In other
words, if the real rate (R) is the same in both Germany and the United
Kingdom, and expectations regarding inflation rates hold true, todays one-year
forward rate is likely to be the same as the future spot rate one year from now.
Thus, in efficient markets, with rational expectations, the forward rate is an
unbiased (not necessarily accurate) forecast of the future spot rate (unbiased
forecast rate or UFR). These relationships between inflation and interest rates,
and spot and forward rates are depicted in Figure 20.2.
Given the available information of inflation rates and interest rates,
we have done our best to forecast accurately. As we will see in the next section,

FIGURE 20.2

EFFICIENT FOREIGN EXCHANGE MARKET RELATIONSHIPS

RATES

Inflation:
Current spot:

EXAMPLE
West
UK
Germany
4%

Expected inflation rates

IFE

2%

Interest rates

PPP

.40/D

IRP
PPP forecast of
future spot:
Interest:

0.408/D
7.12%

Forward rates

5.06%
UFR

IFE-determined
forward:

0.408/D

Forecasts of spot rates

UFR = unbiased forward rate; IFE = International Fisher effect; IRP = interest rate parity; PPP = purchasing power parity

16

such forecasts are useful in eliminating exchange risk for near-term


international transactions, a process called hedging. However, there is no easy
way to hedge long-term cash flows for international operations. As will be
discussed in the next section and in the section on direct foreign investment,
the problem is that the terms of trade can also change. That is, exchange-rate
changes can go beyond PPP-induced changes, leading to real exchange-rate
changes.
If PPP holds, and if there are no real exchange-rate changes, currency
gains and losses from nominal exchange-rate changes will generally be offset
over time by differences in relative rates of inflation between two countries, as
we saw in the preceding widget example. However, real exchange-rate changes
lead to real exchange gains and losses. Consider the situation of Japanese car
makers exporting cars to Australia over a one-year period. Assume Australian
inflation to be about 10% annually over this period with Japanese inflation at
2% p.a. The given yen/A$ spot exchange rates leads to the following situation:
Year

Australian price Actual Yen equivalent


of Japanese car Yen/A$
revenue

1
A$10,000
Inflation
10%
2
A$11,000

200.48

2,004,800

125.41

1,379,510

Yen costs

Yen
profit/(loss)

(1,400,000)
2%
(1,428,000)

604,800
(48,490)

Because the yen strengthened to Yen125.41/$A1, which is far beyond


what the PPP forecast would suggest (i.e. Yen200.48 (1.02/1.10) =
Yen185.90/A$), the yens value increased in real terms. To the extent that
revenues were dollar-based and costs were yen-based (the cars were made in
Japan), the Japanese car makers were at a competitive disadvantage relative to
cars manufactured in Australia. Their costs did not change much while their
yen-equivalent revenues fell by one-third. It is interesting that some Japanese
car companies have created economic hedges to control for this risk, by
building car plants in Australia so that they now have Australian dollar-based
revenues and costs. However, they are still exposed to exchange-rate risk if
they repatriate the dollars to Japan!
EXPOSURE TO EXCHANGE-RATE RISK
Assets or cash flows valued or denominated in a foreign currency will have
different domestic currency values whenever the exchange rate changes. It can
be said that the assets and cash flows are exposed to exchange-rate risk.
However, a possible decline in domestic currency value of assets and cash flows
may be offset by the decline in domestic currency value of liabilities that are
also denominated or valued in the foreign currency. Thus, a firm would

17

normally be interested in its net exposed position (exposed assets minus


exposed liabilities, exposed cash inflows minus exposed cash outflows) for
each period in each currency.
While expected changes in exchange rates can often be included in the
cost-benefit analysis relating to foreign-currency transactions, in most cases
there is an unexpected component in exchange-rate changes and often the costbenefit analysis for foreign currency assets and liabilities does not fully capture
even the expected change in the exchange rate. For example, sales price
increases for the products of the foreign operations may often have to be less
than those necessary to fully offset exchange-rate changes because of the
competitive pressures of local competitors in the foreign country. We saw this
situation earlier with the example of the Japanese car exporters selling in the
Australian market.
Three measures of foreign-exchange exposure that we will examine in
more detail are translation exposure, transactions exposure and economic
exposure. Translation exposure arises because the foreign operation of a
domestic business has its accounting statements denominated in the currency of
the country in which the operation is located. So, for example, with Australian
parent companies, where the reporting currency for their consolidated financial
statements is the Australian dollar, the assets, liabilities, revenues and expenses
of the foreign operations must be translated into Australian dollars.
International transactions often require a payment to be made or received
in a foreign currency in the future, so these transactions are exposed to
exchange-rate risk. Economic exposure exists over the long term because the
value of future cash flows in the reporting currency (e.g. the Australian dollar)
from foreign operations are exposed to exchange-rate risk. Indeed, the whole
stream of future cash flows is exposed and therefore their economic value to
the business can be affected. The three measures of foreign-exchange exposure
are now examined more closely.
Translation exposure
Foreign currency assets and liabilities are considered exposed if their foreign
currency value is to be translated into the parent company currency at a future
date using the exchange rate current at the time of translation, that is, the spot
exchange rate in effect at the balance-sheet date. This is because the domestic
currency value of these foreign currency assets and liabilities will change from
one balance-sheet date to another if the current spot exchange rate used for
the translation changes. These changes in domestic currency value will be
reported as exchange gains and losses in the domestic currency financial
statements.
Asset, liability and equity amounts that are translated at the historic

18

exchange ratethat is, the rate in effect when these items were first recognised
in the companys accountsare not considered to be exposed. This is because
the domestic currency values of these amounts will not change as a result of
spot exchange-rate changes. The rate (current or historic) used to translate
various accounts depends on the translation procedure used and will be
specified by accounting standards.
Any translation exchange-rate gains and losses that are reported in the
domestic currency accounts are unrealised, as the underlying foreign currency
value has not changed, only its domestic currency translated value. Thus, if
financial markets are efficient and managerial goals are consistent with owner
wealth maximisation (and if agency and signalling costs are negligible so that
investors recognise that the gains and losses are a product of accounting
procedures and not cash flows), a firm should not have to use real resources
for hedging against possible unrealised losses caused by translation exposure.
However, if there are significant agency or information costs or if markets are
not efficient (that is, if translation losses and gains raise information costs for
investors, or if they endanger the firms ability to satisfy debt or other
covenants, or if the evaluation of the firms managers depends on translated
accounting data), a firm may indeed find it economical to hedge against
translation losses or gains.
Transactions exposure
Foreign currency accounts receivable, foreign currency accounts payable,
foreign currency fixed-price sales and foreign currency purchase contracts are
examples of transactions where the foreign currency value is fixed at a time
that is different from the time when the transactions produce foreign currency
cash flows. Therefore, at the time these contracts are entered into there is
uncertainty (due to uncertain future spot rates) as to what the domestic
currency value of the resulting foreign currency cash flows will be.
Transactions exposure identifies the amount of net contracted foreign currency
for which the settlement domestic currency cash-flow amounts will vary due
to changing exchange rates. A company normally must set up an additional
reporting system to track transactions exposure, because several of these
amounts are not recognised in the accounting books of the firm.
Translation and transaction exposure may be neutralised or hedged by a
change in the asset and liability position in the foreign currency. For example,
an exposed asset position (e.g. a foreign currency account receivable) can be
hedged or covered by creating a liability of the same amount and maturity
denominated in the foreign currency (e.g. a forward contract to sell the foreign
currency). An exposed liability position (e.g. a foreign currency account
payable) can be covered by acquiring assets of the same amount and maturity

19

in the foreign currency (e.g. a forward contract to buy the foreign currency).
The objective is to have a zero-net-asset position in the foreign currency. This
eliminates exchange risk, since the loss (gain) in the value of the liability (asset)
is exactly offset by the gain (loss) in the value of the asset (liability) when the
spot rate changes. Two popular forms of hedge are the money-market hedge
and the forward-market hedge. In both types of hedge the amount and the
duration of the asset (liability) positions are matched. Note as you read the
next two subsections how IRP theory assures that each hedge provides the
same cover outcome.
Money-market hedge
In a money-market hedge, the exposed foreign currency amount is offset by
borrowing or lending in the money market. For example, consider the case of
an Australian firm with a net foreign currency liability position (i.e. the
amount it owes) of 3,000 Malaysian ringgit. The firm knows the exact amount
of its ringgit liability in 30 days, but it does not know the liability in Australian
dollars. Assume that the money-market rates in both Australia and Malaysia
are 1% for lending and 1.5% for borrowing for 30 days and that the current
spot rate is RM1.8695/A$. The Australian business can take the following
steps to hedge:
Step 1: Calculate the present value of the foreign currency liability (RM 3,000)
that is due in 30 days using the money-market rate applicable for the foreign
country (1% in Malaysia). The present value of RM 3,000 is RM 2,970.30,
computed as follows: 3000/(1 + 0.01).
Step 2: Exchange dollars on todays spot market to obtain the RM 2,970.30.
The dollar amount needed today is A$1,588.82 (2,970.30 / RM 1.8695).
Step 3: Invest RM 2,970.30 in a Malaysian one-month money-market
instrument at 1%. This investment will compound to exactly RM 3,000 in one
month. Thus, the future liability of RM 3,000 is covered by the RM 2,970.30
investment made today.2
Note that if the Australian business does not own today the A$ required
in step 2, it can borrow A$1,588.82 from the Australian money market at the
going rate of 1.5%. In 30 days the Australian business will need to repay
A$1,612.65 [i.e. A$1,588.82 (1 + 0.015)].
Assuming that the Australian business borrows the money, its
management may base its decisions on the knowledge that the Malaysian
goods will cost it A$1,612.65 in 30 days to pay the Malaysian business RM
3,000 ringgit. Thus, the Australian business need not wait for the future spot
exchange rate to be revealed. On todays date, the future dollar payment of
$A1,612.65 for RM 3,000 is known with certainty. This certainty helps the

20

Australian business in making its pricing and financing decisions.


Many large businesses can hedge in the money market. To do so, the
firm needs to borrow (creating a liability) in one market, lend or invest in
the other money market, and use the spot exchange market on todays date.
The mechanics of covering a net-asset position in the foreign currency are the
exact reverse of the mechanics of covering the liability position. A net-asset
position in ringgit would require the Australian business to (1) borrow in the
Malaysian money market in ringgit, (2) convert to dollars on the spot
exchange market, (3) invest in the Australian money market, and (4) when the
net assets are converted into ringgit (i.e. when the firm receives what it is
owed), pay off the ringgit loan and the interest. The cost of a money-market
hedge is the cost of doing business in three different markets. Information
about the three markets is needed, and analytical calculations of the type
indicated here must be made.
Small businesses and infrequent traders find the cost of the moneymarket hedge prohibitive, owing especially to the need for information about
the money market. These firms instead use the forward market hedge provided
by the foreign-exchange market, which has very similar hedging benefits to the
money-market hedge.
The forward-market hedge
The forward market provides a second possible hedging mechanism. A netasset (liability) position is covered by a liability (asset) in the forward market.
Consider again the case of the Australian firm with a liability of 3,000 ringgit
that must be paid in 30 days. The firm may take the following steps to cover its
liability position.
Step 1: Enter into a forward contract today with a foreign exchange bank to
purchase RM 3,000 in 30 days. The 30-day forward rate quoted by the bank is
RM 1.8587 per A$1.
Step 2: On the 30th day pay the bank A$1,614.03 (3,000 / RM 1.8587) and
collect RM 3,000. Pay these ringgit to the Malaysian supplier.
By the use of the forward contract the Australian business knows the
exact value of the future payment in dollars (A$1,614.03). The exchange risk
in ringgit is totally eliminated by the net-asset position in the forward ringgit.
In the case of a net-asset exposure, the steps open to the Australian firm would
be the exact oppositesell the ringgit forward, and on the future day receive
and deliver the ringgit to collect the agreed-on Australian dollar amount.
The use of the forward market as a hedge against exchange risk is simple
and direct. The firm directs its banker that it needs to buy or sell a foreign
currency on a future date, and the banker gives a forward quote.

21

The forward-market hedge and the money-market hedge give an identical


future dollar payment (or receipt) if the forward contracts are priced according
to the interest-rate-parity theory. You may have noticed that the dollar
payments in the examples of the money-market hedge and the forward-market
hedge were, respectively, A$1,612.65 and A$1,614.04. Recall from our
previous discussions that in efficient markets the forward contract rate does
indeed conform to IRP theory. However, the numbers in our example are not
identical because the forward rate used in the forward hedge is not exactly
equal to the interest rates in the money-market hedge. There may be arbitrage
opportunities!
Currency option contracts
The forward-market hedge is not adequate for some types of exposure. For
example, the foreign currency asset or liability position may not be known
with certainty so the forward hedge cannot be accomplished. In addition to
forward-market and money-market hedges, a company can also hedge its
exposure by entering into a foreign currency option contract.
These contracts give the holder the right to choose at or before a
specified future date to buy or sell a foreign currency at an exchange rate
which is set at the time the option contract is entered into. In compensation for
being given this right to choose, the option holder pays an amount at the time
of entering into the option contract called the option premium. The advantage
of an option over a money-market or forward-market hedge is that the option
holder can choose to exercise the option if it is to the holders advantage to do
so and can choose not to exercise the option if so desired. The cost of not
exercising the option is the option premium paid at the start.
Economic exposure
The economic value of a firm can be defined as the present value of its future
cash flows and this value may vary in response to exchange-rate changes. This
change in value may be caused by a rate-change-induced decline in the level of
expected cash flows and/or by an increase in the riskiness of these cash flows.
Economic exposure refers to the overall impact of exchange-rate changes on
the value of the firm and includes not only the strategic impact of changes in
competitive relationships that arise from exchange-rate changes, but also the
economic impact of transactions exposure and, if any, of translation exposure.
Economic exposure to exchange-rate changes depends on the competitive
structure of the markets for a firms inputs and its outputs, and on how these
markets are influenced by changes in exchange rates. This influence, in turn,
depends on several economic factors, including price elasticities of the
products, the degree of competition from foreign markets, as well as direct
(through prices) and indirect (through incomes) impact of exchange-rate

22

changes on these markets. Assessing the economic exposure faced by a


particular firm thus depends on the ability to understand and model the
structure of the markets for its major inputs (purchases) and outputs (sales).
A company need not engage in any overseas business activity to be
exposed to the economic effects of exchange rate changes because product and
financial markets in most countries are related and influenced to a large extent
by the same global forces. The output of a company engaged in business
activity only within one country may be competing with imported products, or
it may be competing for its inputs with other domestic and foreign purchasers.
For example, an Australian chemical company that does no international
business may nevertheless find that its profit margins depend directly on the
US dollar Australian dollar exchange rate. This is because the company uses
oil as an input in its production process, and the Australian domestic price of
oil is heavily influenced by the international price of oil which is denominated
in US$.
In summary, although translation exposure need not be managed, it
might be useful for a firm to manage its transaction and economic exposures
because they affect firm value directly. In most companies, transaction
exposure is generally tracked and managed. Economic exposure is difficult to
define in operating terms, and very few companies manage it actively.
Therefore, in most companies, economic exposure is generally considered part
of the strategic planning process, rather than as a finance function.
MULTINATIONAL WORKING-CAPITAL MANAGEMENT
The basic principles of working-capital management for a multinational
corporation (MNC) are similar to those for a domestic firm. However, tax and
exchange-rate factors are additional considerations for the MNC. For an MNC
with subsidiaries in many countries, the optimal decisions in the management
of working capital are made by considering the company as a whole. This is
because the global or centralised financial decision for an MNC is superior to
the set of independent optimal decisions for the subsidiaries. This is the control
problem of the MNC. If the individual subsidiaries make decisions that are
best for them individually, the consolidation of such decisions may not be best
for the MNC as a whole. To effect global management, sophisticated
computerised modelsincorporating many variables for each subsidiaryare
required to provide the best overall decision for the MNC.
In this section we examine some techniques that are useful in the
management of working-capital.
Leading and lagging
Two important risk-reduction techniques for many working-capital problems

23

leading and lagging


Techniques used to reduce
exchange-rate risk where the firm
speeds up or slows down foreign
currency payments and/or receipts.

are called leading and lagging. Sometimes, forward-market and money-market


hedges are not available in some currencies to eliminate exchange risk. Under
such circumstances, leading and lagging may be used to reduce exchange risk.
A net-asset (also known as a long) position is not desirable in a weak or
potentially depreciating foreign currency as it will be worth less domestic
currency in the future. If a firm has a net-asset position in such a currency, it
should expedite the disposal of the asset. The firm should sell the asset earlier
than it otherwise would have, or lead, and convert the funds into assets in a
relatively stronger currency. By the same reasoning, the firm should lag, or
delay the collection against a net-asset position in a strong currency. If the firm
has a net-liability (also known as a short) position in the weak currency, then it
should delay the payment against the liability, or lag, until the currency
depreciates. In the case of an appreciating or strong foreign currency and a netliability position, the firm should lead the paymentsthat is, reduce the
liabilities earlier than it would otherwise have.
EXAMPLE

20.5

System Grapho Ltd has US$1 million on deposit with its bank, with one
months notice of withdrawal. The current indicative spot rate is
US$0.5300/A$1 and the company expects the value of the AUD to rise in the
future by US$0.0100 per month (i.e. $US expected to depreciate). When should
the company withdraw the US$ and exchange the funds for A$?
Date

Expected spot rate

A$ value of US$1 million

Currently
1 months time
2 months time
3 months time

US$0.5300/A$1
US$0.5400/A$1
US$0.5500/A$1
US$0.5600/A$1

A$1,886,792
A$1,851,852
A$1,818,182
A$1,785,714

As System Grapho Ltd has an asset in a foreign currency which is expected


to fall in domestic currency value, it should lead and give notice of withdrawal
now so that it can exchange the US$1 million of A$ as soon as possible. Given the
requirement for one months notice of withdrawal, the earliest the company can
exchange the US$ asset for A$ is in one months time when its expected value will
be A$1,886,792. If it waits longer to withdraw the US$ then it will receive even
less $A.
These principles are useful in the management of working capital of an
MNC. They cannot, however, eliminate the foreign-exchange risk. When
exchange rates change continuously, it is almost impossible to guess whether or
when a currency will fall in value (depreciate) or rise in value (appreciate). This

24

is why the risk of exchange-rate changes cannot be eliminated. Nevertheless,


the reduction of risk, or the increasing of gain from exchange-rate changes, via
the lead and lag, is useful for cash management, accounts receivable
management, and short-term liability management.
Cash management and positioning of funds
Positioning of funds takes on an added importance in the international context.
Funds may be transferred from a subsidiary of the MNC in country A to
another subsidiary in country B such that the foreign-exchange exposure and
the tax liability of the MNC as a whole are minimised. It bears repeating that,
owing to the global strategy of the MNC, the tax liability of the subsidiary in
country B may be greater than it would otherwise have been, but the overall
tax payment for all units of the MNC is minimised.
The transfer of funds among subsidiaries and the parent company is done
by royalties, fees and transfer pricing. A transfer price is the price a subsidiary
or a parent company charges other companies that are part of the MNC for its
goods or services. A parent that wishes to transfer funds from a subsidiary in a
depreciating-currency country may charge a higher price on the goods and
services sold to this subsidiary by the parent or by subsidiaries from strongcurrency countries. The ability to do this will however be affected by the
transfer pricing tax laws of various countries.
In summary, centralised cash management of all the affiliates at the
global level, achieved with the help of computer models, reduces both the
overall cost of holding cash and the foreign-exchange exposure of the MNC as
a whole.

transfer price The price used


within a firm to value the transfer
of goods and services between
subdivisions.

INTERNATIONAL FINANCING AND CAPITAL-STRUCTURE


DECISIONS
Access to national financial markets is regulated by each countrys government.
For example, in Australia access to capital markets is governed by federal
government regulations administered by the Australian Securities and
Investments Commission, whereas access to Japanese capital markets is
governed by regulations issued by the Japanese Ministry of Finance. Depending
on government regulations, a countrys financial markets can vary from being
very open to being very restricted, where access by foreigners to local finance
and access by locals to overseas financial markets is limited or even prohibited.
As the Australian financial markets are relatively open, Australian businesses
have potential access to not only the financial markets of Australia but also to
the those of many overseas countries.
With the increasing availability of interest-rate and currency swaps, a
firm can raise funds in the lowest-cost maturities and currencies and swap

25

them into funds with the maturity and currency denomination it requires.
Because of its ability to tap a larger number of financial markets, a large
domestic firm may have a lower cost of capital than smaller firms limited to
raising funds domestically. Also, these larger firms may be better able to avoid
the problems or limitations of any one financial market, and therefore may
have a more continuous access to external finance compared to a purely
domestic fund raising company.
The external financial markets are predominantly centred in Europe, and
Euromarkets Financial markets
involving currencies that are held
outside their country of origin.

they are referred to as Euromarkets. The Euromarkets consist of an active shortterm money market and an intermediate-term capital market with maturities
averaging about 7 to 9 years and ranging up to 15 years. The intermediate-term
market consists of the Eurobond and the Syndicated Euro credit markets.
Eurobonds are usually issued as unregistered bearer bonds3 and generally tend to
have higher flotation costs but lower coupon rates compared to similar bonds
issued in the home country. A Syndicated Euro credit loan is simply a large term
loan that involves contributions by a number of lending banks. Most Australian
banks, government finance authorities and large companies are active in the
external capital markets and raise funds in a range of currencies.
In arriving at its capital-structure decisions, a company with foreign
operations has to consider a number of factors. First, the capital structure of
its local affiliates is influenced by local norms regarding debt and equity in
that industry and in that country. Local norms for companies in the same
industry can differ considerably from country to country. Second, the local
affiliate capital structure must also reflect corporate attitudes towards
exchange rate and political risk in that country, which would normally lead to
higher levels of local debt and other local capital. Third, local affiliate capital
structure must reflect home-country requirements with regard to the
companys consolidated capital structure. Finally, the optimal MNC capital
structure should reflect the companys wider access to financial markets, its
ability to diversify economic and political risks, and its other advantages over
domestic companies.
DIRECT FOREIGN INVESTMENT
An MNC often makes direct foreign investments abroad in the form of plant
and equipment. The decision process for this type of investment is very similar
to the capital-budgeting decision in the domestic contextwith some
additional twists. Most real-world capital-budgeting decisions are made with
uncertain future outcomes. Recall that a capital-budgeting decision has three
major components: the estimation of the future cash flows (including the initial

26

cost of the proposed investment), the estimation of the risk of these cash flows,
and the choice of the proper discount rate to reflect the risk. We will assume
that the NPV criterion is appropriate as we examine (1) the risks associated
with direct foreign investment and (2) factors to be considered in making the
investment decision that may be unique to the international scene.
Risks in direct foreign investments
Risks in domestic capital budgeting arise from two sources: business risk and
financial risk. The international capital-budgeting problem incorporates these
risks as well as political risk and exchange risk.
Business risk and financial risk
International business risk is due to the uncertainty of economic conditions in
the foreign country. Thus, the Australian MNC needs to be aware of the
business climate in both Australia and the foreign country. Additional business
risk is due to competition from other MNCs, local businesses, and imported
goods. Financial risk refers to the risks introduced into the profit stream by the
firms capital structure. The financial risks of foreign operations are not very
different from those of domestic operations.
Political risk
Political risk arises because the foreign subsidiary conducts its business in a
political system different from that of the home country. For example, many
foreign governments are less stable than the Australian government. A change
in a countrys political setup frequently brings a change in policies with respect
to businessesand especially with respect to foreign businesses. An extreme
change in policy might involve nationalisation or even outright expropriation
of certain businesses. These are the political risks of conducting business
abroad. A business with no investment in plant and equipment is less
susceptible to these risks as it can more easily move its operations elsewhere.
Some examples of political risk are listed below:
expropriation of plant and equipment without compensation;
expropriation with minimal compensation that is below actual market value;
non-convertibility of the subsidiarys foreign earnings into the parents
currencythe problem of blocked funds;
substantial changes in the laws governing taxation;
governmental controls in the foreign country regarding the sale price of the
products, wages and compensation to personnel, hiring of personnel,
making of transfer payments to the parent, and local borrowing;
requirements of certain amounts of local equity participation in the
business. Some governments require that the majority of the equity
participation should belong to their country.

27

All these controls and governmental actions introduce risks to the cash
flows of the investment to the parent company. These risks must be considered
before making the foreign-investment decision. The MNC may decide against
investing in countries with risks of expropriation. Other risks can be borne
provided that the returns from the foreign investments are high enough to
compensate for them. Insurance against some types of political risks may be
purchased from private insurance companies or from the Australian
government Export Finance and Investment Corporation (EFIC).
Exchange risk
The exposure of the firms assets is best measured by the effects of exchangerate changes on the firms future-earnings streamthat being economic
exposure rather than translation exposure. For instance, changes in the
exchange rate may adversely affect sales by making competing imported goods
cheaper. Changes in the cost of goods sold may result if some components are
imported and their price in the foreign currency changes because of exchangerate fluctuations. The thrust of these examples is that the effect of exchangerate changes on income-statement items should be properly measured to
evaluate exchange risk. Finally, exchange risk affects the dollar-denominated
profit stream of the parent company, whether or not it affects the foreigncurrency profits.
If the foreign sales volume is expected to be low, the MNC may consider
setting up a sales office in the foreign country. The product may be exported to
the foreign country from production facilities in the home country or from
some other foreign subsidiary. An NPV calculation may now be employed and
the acceptance of this scheme is ensured, because no direct capital investment
is needed. If the estimated sales levels are high enough that the establishment
of a plant in the foreign country appears profitable (owing to the potential
savings in the transportation costs), yet the NPV of the direct foreign
investment (DFI) is negative, the MNC may consider licensing or an affiliate
arrangement with a local company. The MNC provides the technology, and
the interested domestic firm finances and sets up the plant. The MNC does not
bear the risks of a DFI, but receives a royalty payment from the sales of the
affiliate company instead.
EXPORT AND SMALL AND MEDIUM ENTERPRISES
When discussing international aspects, especially international financing, we
tend to think of large multinational companies. However, there is an important
international perspective for small and medium enterprises (SMEs) in relation
to exports.
Australia is part of a world-wide trend whereby SMEs are playing an

28

increasingly significant role in exporting to specialised world markets. For


example, in the United States more than half of all exporting firms are
estimated to have less than 100 employees.4 Over 80% of exporters in the
Australian manufacturing sector and 60% of exporting firms in the service
sector have been classified as being small or medium size.5 Big companies
remain essential, but there is a fundamental shift in the way that much of the
world does business and Australia is part of the global change.
Foreign investment
Foreign or offshore investment need not be confined to large companies. There
are numerous benefits for SME exporters who receive and/or make foreign
investments. This is especially important for foreign equity as there is a
shortage of equity finance for SMEs in Australia.
Alliances with overseas investors and companies provide access not only
to funds, but also to technology, management skills and new markets.
Government assistance
Many countries have external trade organisations to provide export facilitation
assistance in the form of general information, market research, promotion, and
detailed information such as technical requirements and export documentation.
Loan guarantees, credit insurance and financial assistance for exports may be
provided. Such assistance is usually available to firms of all sizes; however,
some countries such as the US and Japan have specifically targeted SMEs for
export assistance. Australian governments have from time to time initiated
programs to facilitate small and medium-sized business export activity mostly
administered by Austrade.
HOW FINANCIAL MANAGERS USE THIS MATERIAL
Financial managers are responsible for the firms financial assets, obligations
and cash flows. If these are denominated in a foreign currency then financial
managers need to be familiar with the material in this chapter. In particular,
they need to know how to read exchange rates, assess exchange-rate risk and
use the various tools available to manage that risk.
SUMMARY
The growth of our global economy, the increasing number of multinational
corporations, and the increase in foreign trade itself underscore the importance
of the study of international finance.
For most currencies, exchange rates vary in an apparently random
fashion in accordance with the supply-and-demand conditions in the foreign
exchange market. Important economic factors affecting the level of exchange

29

rates include the relative economic strengths of the countries involved, the
balance-of-payments mechanism, and the countries monetary policies. Several
important exchange-rate terms were introduced. These include the bid and ask
rates, which represent the buying and selling rates of currencies quoted by
foreign-exchange dealers. Cross-rates reflect the exchange rate between two
foreign currencies which dont include the US$. Finally, simple arbitrage was
shown to hold in an efficient market. The efficiency of spot exchange markets
implies that no arbitrage (riskless) profits can be made by buying and selling
currencies in different markets.
The forward-exchange market provides a valuable service by quoting
rates for the delivery of foreign currencies in the future. The home currency is
said to sell at a forward premium (discount) when the home currency is worth
more (less) foreign currency forward than at spot. The computation of the
percent-per-annum deviation of the forward rate from the spot rate was used
to demonstrate the interest-rate-parity (IRP) theory, which states that the
forward contract sells at a discount or premium from the spot rate, owing
solely to the interest-rate differential between the two countries. The IRP
theory was shown to hold by means of the covered-interest-arbitrage. In
addition, the influences of purchasing power parity (PPP) and the international
Fisher effect (IFE) in determining exchange rates were discussed. If markets are
rational and efficient, forward rates are unbiased forecasts of future spot rates
that are consistent with the PPP.
Exchange risk exists because the exact spot rate that prevails on a future
date is not known with certainty today. The concept of exchange risk is
applicable to a wide variety of businesses including export-import firms and
firms involved in making direct foreign investments or international
investments in securities. Exchange exposure is a measure of the amount of
foreign currency exposed to exchange risk. There are different ways of
measuring the exchange exposure, including the net asset (net liability)
measurement. Different strategies are open to businesses to counter the
uncertainties of the domestic currency value of foreign currency exposure,
including the money-market hedge, the forward-market hedge and options.
Each involves different costs.
In discussing working-capital management in an international
environment we find leading and lagging techniques useful in minimising
exchange risks and increasing profitability. In addition, funds positioning is a
useful tool for reducing exchange-risk exposure. The MNC may have a lower
cost of capital because it has access to a larger set of financial markets than a
domestic company. In addition to the home, host, and third-country financial
markets, the MNC can tap the rapidly growing external currency markets. In
making capital-structure decisions, the MNC must consider political and
exchange risks and host and home country capital-structure norms.

30

The complexities encountered in the direct foreign-investment decision


include the usual sources of riskbusiness and financialand additional risks
associated with fluctuating exchange rates and political factors. Political risk is
due to differences in political climates, institutions, and processes between the
home country and overseas countries. Under these conditions the estimation of
future cash flows and the choice of the proper discount rates are more
complicated than for the domestic investment situation. Rejection of a direct
foreign investment proposal may lead either to the setting-up of a sales office
abroad or to an affiliate arrangement with a foreign company.
Finally, the importance of small and medium enterprises in developing
the export sector of the Australian economy was identified, together with some
of the ways in which the federal government is assisting this development.

STUDY

QUESTIONS

20-1

What additional factors are encountered in international financial management


as compared with domestic financial management? Discuss each factor briefly.

20-2

What different types of businesses operate in the international environment?


Why are the techniques and strategies available to these firms different?

20-3

What is meant by arbitrage profits?

20-4

What are the markets and mechanics involved in generating (a) simple arbitrage
profits, (b) covered interest arbitrage profits?

20-5

How do the purchasing power parity, interest rate parity, and the Fisher effect
explain the relationships between the current spot rate, the future spot rate, and
the forward rate?

20-6

What is meant by (a) exchange risk, (b) political risk?

20-7

How can exchange risk be measured?

20-8

What are the differences between transaction, translation and economic


exposures? Should all of them be ideally reduced to zero?

20-9

What steps can a firm take to reduce exchange risk? Indicate at least two
different techniques.

20-10 How are the forward-market and the money-market hedges effected? What are
the major differences between these two types of hedges?
20-11 Assume that in the Australian foreign-exchange market the forward rate for the
Indian currency, the rupee, is not quoted. If you were exposed to exchange risk in
rupees, how could you cover your position?
20-12 Indicate two working-capital management techniques that are useful for
international businesses to reduce exchange risk and potentially increase profits.
20-13 How do the financing sources available to a large company with access to
overseas financial markets differ from those available to a firm that can only
access the domestic markets? What do these differences mean for the companys
cost of capital?

31

20-14 What risks are associated with direct foreign investment? How do these risks
differ from those encountered in domestic investment?
20-15 How is the direct foreign-investment decision made? What are the inputs to this
decision process? Are the inputs more complicated than those to the domestic
investment problem? If so, why?
20-16 A corporation desires to enter a particular foreign market. The analysis indicates
that a direct investment in the plant in the foreign country is not profitable. What
other course of action can the company take to enter the foreign market? What
are the important considerations?
20-17 What are the reasons for the acceptance of a sales office or licensing arrangement
when the direct foreign investment itself is not profitable?

SELF-TEST

PROBLEMS

A foreign exchange dealer in Sydney currently quotes buying/selling French franc (FRF):
Country
France (franc)

Contract

FRF/AUD 1

Spot
30 day
90 day

3.893/3.824
3.876/3.802
3.834/3.754

Use the above data for self-test problems ST-1 and ST-2.
ST-1

You own A$10,000. In Tokyo at the same time you could exchange your A$ for
franc 39,750. Are arbitrage profits possible? Set up an arbitrage scheme with
your capital. What is the gain (loss) in dollars?

ST-2

If the interest rates on 30-day money market instruments in Australia and France
are 14% and 10% (annualised) respectively, what is the correct price of the
30-day forward franc?

STUDY

PROBLEMS

A dealer in Sydney quotes buying/selling foreign currencies:


Country
Canada (dollar)

Japan (yen)

Switzerland
(franc)

Contract
Spot
30 day
90 day
Spot
30 day
90 day
Spot
30 day
90 day

Foreign currency/AUD 1
1.1043/1.1030
1.1023/1.1008
1.0980/1.0963
73.78/72.48
73.41/72.06
72.58/71.23
0.9542/0.9370
0.9579/0.9402
0.9640/0.9461

Use the above data for the following study problems.

32

20-1

An Australian business needs to pay in 2 business days (a) 10,000 Canadian


dollars, (b) 2 million yen, and (c) 50,000 Swiss francs to businesses abroad. What
are the dollar payments required to obtain the foreign currencies?

20-2

An Australian business pays $10,000, $15,000, and $20,000 to suppliers in,


respectively, Japan, Switzerland and Canada. How much, in local currencies, do
the suppliers receive in 2 days business time?

20-3

Compute the A$ equivalent for the spot Canadian dollar, yen and Swiss franc
spot exchange rates.

20-4

You own A$10,000. The spot exchange rate quoted in Tokyo is Yen 75.20/73.90
per A$1. Are arbitrage profits possible? Set up an arbitrage scheme with your
capital. What is the gain (loss) in dollars?

20-5

Compute the percent-per-annum premium (discount) on the 30-day and 90-day


yen, Swiss franc, and Canadian dollar buying quotes.

20-6

Assume that the interest rate on the Australian 30-day treasury bill is 15%
(annualised). The corresponding Canadian rate is 18%. Can an Australian trader
make arbitrage profits? If the trader had A$100,000 to invest, indicate the steps
he or she would take. What would be the net profit? (Ignore transactions and
other costs.)

20-7

If the interest rates on the 30-day instruments in Australia and Japan are 15%
and 12% (annualised) respectively, what should be the correct price of the
30-day forward dealer selling yen rate? Use the spot rate from the table.

20-8

The 30-day treasury-bill rate in Australia is 15% annualised. Using the 30-day
forward selling quotes, compute the 30-day interest rates in Canada, Switzerland
and Japan implied by the forward rates.

SELF-TEST
SS-1

SOLUTIONS

The Sydney dealer is selling French francs at a spot rate of FRF 3.800/A$1, while
in Tokyo the same rate is quoted as FRF 3.975/A$1 [FRF 39,750/10,000].
Assuming no transaction costs, the rates between Sydney and Tokyo are out of
line. Thus, arbitrage profits are possible.
Step 1: Because the A$ is worth more francs in Tokyo you should sell your
A$10,000 for francs to the Tokyo dealer at FRF 3.975/A$1 [dealer sell francs
rate] and receive FRF 39,750.
Step 2: Simultaneously agree to sell the francs in Sydney at the quoted rate of
FRF 3.893 /A$1 [dealer buy FRF]. The amount received on the sale of the francs
would be: francs 39,750/3.893 = A$10,210.63. Thus, you would make a net
arbitrage gain of A$210.63

SS-2

Step 1: Compute the percent-per-annum discount/premium on the forward rate


using equation 20-2:
P (or D) =

0.10 0.14
= 0.035 = 3.5% p.a. forward discount of A$
1 + 0.14

33

Step 2: Using this discount, calculate the forward rate from equation 20-1:
3.5 =

F 3.893
12

100 = FRF 3.882


3.893
1

This result indicates that IRP is not applying, as the quoted 30-day buying rate of
FRF 3.876 is different from the rate calculated from the interest-rate differentials
FRF 3.882. As a consequence, covered interest arbitrage opportunities exist.

NOTES
1. Repatriation of profits refers to the withdrawal of profits from foreign operations
to the home country of the MNC.
2. Observe that 2,970.30 ringgit (1 + 0.01) = 3,000 ringgit.
3. With an unregistered bearer bond the bond owners identity is not known to the
bond issurer. The coupon payments and final principal payments are made to
the person who physically presents the bond (the bearer) to the issuer at the
appropriate payment dates.
4. Birch, D. L. 1988, Trading Places, Inc, April, pp. 4243.
5. Marsden, J. & Associates 1995, Financing Growth, Department of Industry,
Science and Commerce, Canberra.

34